Pareto's Republic and the New Science of Peace
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By socializing decisions about private property, these governments drag us into the arena of conflict that was so well trodden in East Bloc countries. Socialism is by definition lawless because it puts all decisions about private property in public hands. In public hands, the sole and final arbiter is the strength of the ruling interest group. Socialization of divisible, rivalrous property rights is a problem that governments bring upon themselves needlessly. By diverting people from seeking cooperative solutions to society’s collective problems, the socialization of private property makes each of us an enemy to the rest of us. The lowered tone of “political discourse” that scholars have identified in recent decades may result from the socialization of private property. Problems of social conflict are attenuated when government concerns itself strictly with providing public, non-rivalrous goods and protecting the natural commons, because these issues deal with questions of collective well-being. Publicly provided rivalrous goods pit each man and woman against the other. No wonder political change has become nearly impossible in most developed countries. Too much of what could be peacefully resolved by individuals trading private property under the rule of law has been moved into the combat zone of public ownership.
So what about fairness?
I have not mentioned fairness so far in this chapter, which may seem a major omission as most people believe that government should have some role in determining a fair division of resources. Instead, I have argued that government’s only role in society is to plug gaps left when private property rights malfunction, and that even then, government should divest itself of managing these resources once privatization becomes feasible. To understand the role of fairness in Pareto’s Republic, we need to distinguish between the concept’s two variants.
The first variant is distributional fairness. It is a criterion for dividing society’s resources separately from any decisions individuals might make. As explained in the previous chapter, distributional fairness was the major preoccupation of former East Bloc countries when they made the transition from socialism to the free market. To make the transition, governments had to transfer the bulk of their holdings into private hands. Pareto efficiency was useless as a guide because there were too many Pareto-efficient initial distributions to choose from. Countries in transition had to rely on societal notions of fairness in the transfer and they had to make sure that no individual could influence his or her own particular slice of the pie, a condition that was honoured more in the breach than in the observance.
Once they had transferred resources into private hands, these countries had to implement the second form of fairness, procedural fairness. This is a criterion for managing resources once the initial distribution is done and it can depend heavily on individual choice. The two main forms of procedural fairness available in large societies are management of resources by government officials and management by people holding private property. Having emerged from state management, transition economies naturally strove to create economies based on private property, trusting in the second theorem of welfare economics which holds that the “lump-sum” transfers they made to their people would lead to one specific Pareto-efficient outcome for society. This is an arid but correct way of saying that once you put private property into people’s hands and allow them to trade freely in a market, these people will seek out and find how best to exchange their initial endowments in a Pareto-efficient manner.
The distinction between distributive and procedural fairness needs to be refined to account for the fact that chance frequently undoes any initial fair distribution governments make. The “slings and arrows of outrageous fortune” and the “heartaches and thousand natural shocks that flesh is heir to,” as Shakespeare put it, are relentlessly challenging the accomplishments of static fairness. A man’s house may burn to the ground. A woman may win the lottery. Some are born with great intellectual gifts, or a passion for life, while others cannot chase off the black dog of depression. Private insurance can protect us from some disasters, but there is no policy than can shield us from all the bad knocks we may take through life, especially not in the presence of something called moral hazard. There is an old joke about two farmers discussing insurance. The first one says that he has just bought fire and hail insurance. The second says, “I understand about the fire insurance, but how do you make it hail?” Insurance in this joke is a hazard to the farmer’s morals because he or she may be tempted to burn the crop in order to collect on the policy. What is not funny is that when people act on moral hazard, they are violating the property rights of insurers in such a manner that can cause the market to collapse.
The presence of cheaters drives up the cost of insurance. The increased cost discourages some honest people from buying insurance. A vicious cycle may start because each honest person that is discouraged leaves behind an insurance market increasingly saturated with cheaters. Insurers must continue raising rates, which drives out more honest people, which in turn increases rates to the point where the market disappears. In some East European countries this is so grave a problem that no one will insure motor vehicles or business structures. The impossibility of creating sustainable property rights in some markets is not a blanket excuse to invite government to provide such insurance simply because there is no indication that government can do any better than the private market at identifying cheaters or eliminating moral hazard. The mammoth financial collapses that have followed government attempts to insure the real estate market suggest that government may in fact be the main instigator of moral hazard in society.
Government is on firmer ground in arguing that because we have a tendency to free ride on the charity of others, the private alms given may not suffice. Charity can be considered a public good in the sense that the money I give to the needy benefits not just the needy but also those who sympathize with them. In small, stable communities social pressures force people not to free ride on the charity of others, as any office worker well understands during collection drives by the office representative for the United Way or other such charities. In larger, more anonymous settings, social pressures do not suffice to stop some from riding off the charitable efforts of others. Such, then, is the setting in which government may take from some to give to others, an apparent violation of Pareto efficiency, if those others agree that sometimes the needy need a leg up that private charity cannot provide.
We can fold a layer of fairness into Pareto efficiency by arguing that if private markets fail to correct the most egregious outrages of chance, government may need to take something from nature’s favourites and hand that something to its outcasts in the name of providing a public good. The challenge, of course, is to know just who these favourites are. Without such a guide, fairness may become a byword for theft and lead to discord in society, setting men and women against each other in a mockery of Pareto efficiency. In the case of help for the poor, as in the case of any other good or service, government must stay vigilant to the possibility of devolving charity to the private sector. That possibility arises when the private sector manages to overcome, or at least abate, the free-rider problem.
Pulling the ideas together
This chapter’s main idea can be summed up in a few sentences. We have seen that government is needed in Pareto’s Republic in order to impose solutions that can resolve collective problems concerning property. Individuals in large groups cannot arrive at solutions to these problems by peaceful agreement because some will shirk their obligations and others will get their way by violence. Citizens are willing to give government a monopoly on the use of force, but only to the extent that this force is applied equally to everyone, a concept known as the rule of law. Without the rule of law, government gives itself over to arbitrariness and can become the tool of shirkers and predators in society. Under arbitrary government, property rights lose their power as a medium for resolving disputes. Those who control government and its monopoly of force can resolve disputes by the self-serving application of violence.
Such governments also turn nature into a vast common property pool which the rulers can devastate with impunity.
The government that manages to impose the rule of law rather than martial law allows individuals to stop worrying about official kleptocrats and frees them to specialize and excel at producing something useful. Ultimately government should abandon providing a public good or protecting a commons when a technology comes along that allows the commons to be privatized, or a public good to be charged for on a pay-per-use basis. Governments that provide private goods reproduce the tragedy of the commons and forfeit the peaceful resolution of disputes made possible by private property rights.
All of the above analysis speaks to the benefits we get from government provision of services and goods. What about the costs? So far I have given the impression that if a bridge costs a million dollars to build, that is the cost. As the next chapter explains, the cost of government intervention goes beyond the simple bill in dollars and cents. The extra charge is called a deadweight loss. This is one of the most subtle concepts in economics and holds a special place in calculating how government should enhance Pareto efficiency.
TAXES
When people say that taxes are a necessary evil, they are speaking the language of Pareto efficiency, perhaps without knowing they are doing so. Taxes are necessary because public goods such as street lighting, national defense, and the legal system cannot be charged for directly due to their non-excludable character, as discussed in the last chapter. Government needs to charge for these services indirectly by levying taxes that go into the government treasury. This tax money can then pay for the protection of property rights and common property resources, which, as we saw, are necessary prerequisites to obtaining Pareto efficiency. Yet taxes can also be to some degree evil. The simple act of taxation, considered separately from the benefits of the public goods they finance, is a direct threat to Pareto efficiency. Taxes discourage what once were Pareto-efficient private purchases and guide people into unproductive pursuits merely to avoid paying the levies. On the walls of some British and Canadian houses from the 19th century you can see the outlines of what were windows. People bricked them over to avoid the “window tax.” Purely in response to the tax, people defaced their homes and opted to lurk in domestic shadows, in as stark a retreat from Pareto efficiency as you can find.
More commonplace effects of taxes are to discourage people from entering into exchanges that would have been mutually profitable. Taxes discourage people from buying and merchants from selling. They discourage businesspeople from investing, and workers from upgrading their skills. Taxes do this by putting a wedge between what someone is willing to pay and the other person is willing to accept in payment. Before the imposition of a goods and services tax, the carpenter and I may have agreed that $20 was an acceptable hourly wage, but after the tax is introduced, the carpenter will have to ask me for more money. The tax has come between our mutually acceptable arrangement and I will cut back on my use of his or her services. The problem that governments face is that of trying to enhance Pareto efficiency by providing their citizens with public goods while at the same time keeping down the disruptions to Pareto efficiency from raising the taxes needed to buy those goods. A tale of two countries illustrates this principle.
Colbert and the rise of efficient taxation
In 1661, Louis XIV started to build the world’s grandest palace near the village of Versailles from which his Bourbon clan would impose its will on Europe for three generations. In 1886, Mad King Ludwig of Bavaria began an architectural quest of equally breathless audacity. It brought him abdication and likely assassination. Ludwig drained his coffers and borrowed heavily from the state to finance a building spree that ended with an attempt to reproduce the palace of Versailles on a desolate island in the middle of a Bavarian lake. Though a strong swimmer, he was found shortly thereafter drowned in knee-deep water. France and Bavaria remain proud of these structures, even though historians tend to view both palaces as symbols of royal excess.
The economic view is not to judge these architectural tableaux by their appearance, but to consider how much disruption the financing of these palaces caused in people’s lives. Louis XIV was able to finance Versailles and secure Bourbon power for a further hundred years because the French knew how to devise efficient systems of taxation that spread taxes evenly over many people and also over time, thereby lightening the load the average individual had to carry. King Ludwig, on the other hand, knew little of efficient taxation. He concentrated his energies on his pharaonic projects and on carousing with his servants, rather than listening to the counsel of his expert advisors who warned against debt and fractious debates about who should pay it. Behind his financial excesses loomed giant tax burdens that threatened economic catastrophe for Bavaria.
King Louis’ minister of finance, Jean-Baptiste Colbert, considered efficient taxation as the art of “plucking the goose so as to obtain the largest amount of feathers with the least possible amount of hissing.” A less elegant modern restatement is that taxes should interfere as little as possible with Pareto efficiency. As Louis demonstrated, Pareto-efficient taxation can elevate a Sun King and allow him to build outsize palaces without being deposed by his people. The ruler who ignores this principle upsets commerce and may end up floating face down in three feet of water. All of which goes to show that, not only are death and taxes inevitable, there is some indication that for dissolute royals at least, they can also go in tandem.
To pluck the goose with minimal hissing, Colbert tried not to pile too many taxes on too few people. A heavy burden on one person is far more noticeable and disruptive than a light burden spread over many. One of the chief challenges to spreading the burden evenly was that so many people evaded taxes. Colbert’s efforts to force tax evaders to open their purses helped him to spread the weight of taxation evenly. This diminished the disturbances to the economy that taxation caused, and in this minimally disturbed climate, the French government was able to grow larger than that of any comparable European nation.
Colbert’s insight was not unique. During the reign of King William III in the late 17th century, the British diminished the disruptiveness of their taxes by imposing excise taxes, that is, broadly based taxes collected on sales within the country. Some argue that this enabled the British to finance the armies that thwarted the French in the wars from 1688 to 1714. Three hundred years later, Nobel Prize winning economist Gary Becker and his colleague Casey Mulligan gave Colbert statistical vindication by showing that countries where taxes are spread proportionally also tend to have large governments. Proportional spreading is what today is called a flat tax. Examples of flat taxes are unemployment insurance, contributions to public pensions, property levies, and value-added taxes. France relies on flat taxes for more than eighty percent of its revenues. The United States gets less than forty percent of its revenues from flat taxes and instead relies heavily on progressive income and corporate taxes. In France, government is large. In the US, it is small by comparison. Perhaps Americans do not like big government. Or perhaps, unlike the French, their system of taxation is not efficient enough to allow them to afford it.
Deadweight loss and efficient taxation
Today researchers examining efficient taxation have clarified in modern terms what Colbert was intuitively putting into practice during the age of the Sun King. Efficient tax theory begins with the postulate that the cost to society of a tax is more than just the tax revenue that government takes in.
Pause and think about this, because it is the central idea motivating all of tax policy in pretty much every country. When government raises a million dollars in taxes, is not one million dollars the cost that people bear? The answer is no. People bear the one million dollars and then some. Economists call that “then some” the deadweight loss of the tax. To understand this we need to refine the distinction made above between the direct money cost of a tax to the person paying, and the additional sting economists call deadweig
ht loss.
A tax has recuperable and non-recuperable components. The money government puts into its coffers is not lost. It is just a transfer from taxpayers to government that sits in some consolidated revenue fund ready to be spent on bridges or other enterprises of collective interest. This is the recuperable cost of the tax. Beyond this cost, the tax may discourage investment, consumption, work effort, and may force people to toil in the so-called underground economy, where taxes are undeclared, and government regulations on worker safety are ignored. These are all disruptions from the normal way in which economic exchanges between people would take place without taxation. The value of these lost opportunities cannot be recuperated. Economists call these deadweight costs, or more meaningfully but less commonly, excess burdens.
During the 20th century, many a fine mind in economics proposed ways in which government could devise taxes that minimize the deadweight loss to society per dollar of government revenue. This is a cryptic comment that can very easily be confused with meaning that government should minimize total deadweight losses. What is the distinction? To understand why it is that government must minimize the deadweight losses per dollar of tax revenue and not total deadweight losses, think of taxes as crops and of government as a farmer. It costs the farmer effort and material to harvest each crop. The farmer’s objective is not to minimize the total cost of the harvest. He or she could do that simply by not harvesting! The objective is rather to minimize the cost for each crop brought in. In the same way, the theory of optimal taxation accepts that a government needs to raise a sum of money that can vary according to its needs: the government crop.